Time to plan tax! What are the various Tax Saving Funds and how should one choose among them?

Equity linked savings schemes (ELSS) are equity funds with a 3 year lock in which also give you benefit under Section 80C of the Income Tax Act. There is an outer limit of Rs.1.50 lakhs on Section 80C of which ELSS funds are one of the items of investment. The beauty of the ELSS is that it combines tax saving with wealth creation. Also the 3 year compulsory lock in period ensures that the fund manager does not have to maintain too much in liquid cash which makes the fund allocation a lot more optimal.

Top performing ELSS funds in India

The table below captures some of the best performing tax saving ELSS funds in India. We have only considered the returns over 3 year period and the 5 year period, since these ELSS funds have a minimum lock in period of 3 years.

Name of the Fund

AUM

3-year returns

5-year returns

Axis Long Term Equity

Rs.1504 crore

13.1%

21.2%

DSP Tax Saver

Rs.574 crore

12.6%

18.1%

CR Equity Tax Saver

Rs.57 crore

10.9%

15.1%

ICICI Pru LT Equity

Rs.425 crore

10.7%

16.8%

Quantum Tax Saving

Rs.64 crore

11.3%

14.4%

For comparison we have considered the Direct Plans in all the above cases. What needs to be remembered that these are annualized returns in the above cases. The actual effective returns after considering the tax break effects will be much higher. Why does that matter?

How the tax break helps

The tax break comes in the form of deduction in the year of investment. Let us assume that you invest Rs.10,000 in an ELSS fund and that grows to Rs.12,000 at the end of 1 year. Of course, there is a lock in period of 3 years so you cannot redeem after 1 year. But for academic purposes, the one year return would be 20%. That is the actual return what would be the effective returns on the ELSS fund. For example, when the investor put in Rs.10,000 in an ELSS fund, he gets a tax rebate of 30% in that year. For simplicity we are ignoring the surcharge and cess and are also assuming that he has not yet fully utilized the Section 80C benefit. This is how it will work out.

When he invests Rs.10,000, he gets a tax exemption of Rs.3,000, assuming that his peak tax rate is 30%. That means his net investment of Rs.7,000 (10,000 – 3,000) has actually grown to Rs.12,000 in one year. That is a return of over 70% in one year. That looks really whopping. The tax break under ELSS alone has given that additional 50% returns per annum for the investor. When you look at ELSS funds that way, the returns are a lot more handsome and alluring.

How to go about selecting your ELSS funds?

You can adopt some basic rules for ELSS fund selection. Here is a selection of 5 rules that you can follow for taking your ELSS pick.

Check historic performance of returns over a 3 year period and a 5 year period. That not only shows consistency but also is more relevant considering that the ELSS has a minimum lock in period of 3 years.

Don’t forget the risk aspect. Remember, when you buy equities, fund managers are often tempted to take on higher risk. That can be gauged through the Sharpe and Treynor ratios. Avoid funds that are too risky, since you are locked in for 3 years.

Check the portfolio turnover ratio. As an ELSS fund, your fund manager is required to keep turnover low. There is no reason for him to jump in and out of the market since there are no liquidity pressures. Focus on the ELSS funds with low turnover.

Reasonable AUM is a must. Ideally we suggest a minimum AUM of Rs.500 crore so that the fund manager has a decent corpus to buy and hold on to quality stocks. Also the liquidity pressures will be lower in this case.

Lastly, should you invest in ELSS funds once the Section 80C limit is exhausted, since there is no upper limit? We are against that idea. An ELSS investment has a mandatory lock in of 3 years. The return advantage over equity funds (without considering tax benefits) is not significant. Hence, once your limits are exhausted, you can stick to pure equity funds where liquidity is not a constraint from the first day itself.

In an ELSS plan, if you invest in SIP, you can withdraw only on completion of 3 years for each SIP investment. The first SIP installment will be withdrawn only after 36 months of your first SIP investment. The second installment of SIP can be withdrawn only after 36 months of that SIP installment. So, in ELSS 3 years lock-in-period is counted on each SIP installment of your investment.